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Are Low-Yielding Bonds Still A Good Stock Market Hedge?

One thing that’s stood out during the most recent stock market turmoil is that bonds aren’t performing all that well either. US Treasury Bonds are up just 3.5% since stocks peaked and the aggregate bond index is up less than 1%. The concern here is that ultra-low yielding bonds can’t decline sustainably below 0% and are therefore unlikely to provide much downside protection in the future, whereas environments like the 2008 financial crisis and before offered investors far more protection because yields were higher. There’s some sad math behind the reality of falling bond yields [ insert sad trombone] . As yields approach the 0% mark they produce less and less potential upside. Here’s a general guideline for how much protection you’ll get from 10-year yields falling by 50% from 6% all the way down to 0.19%: As your yield gets cut in half so too does your upside protection. In other words, low yielding bonds become a worse and worse hedge as the yields decline. And herein lies the problem of a diversified portfolio. Investors who are used to a portfolio like the 60/40 of the 80s, 90s and 00s are in for a nasty surprise. Their 60% stock slice is now generating even more “permanent loss” risk than ever. And their bond slice is acting more and more like a true cash component. This puts the traditional 60/40 investor in a bind. They’re going to have to start deviating from 60/40 if they want to generate the same type of nominal and risk-adjusted returns because there is simply no way their bond component can protect them to the same degree that it once did. In fact, if rates become more positively skewed in the years ahead, the bond piece might contribute more “permanent loss” risk in the near term than many of these investors are hoping for. This doesn’t mean that bonds can’t still be a good hedge for stocks, but it does mean that diversified investors are likely to increasingly deviate from 60/40 as they realize that this allocation doesn’t offer the same types of returns that it did in a high and falling interest rate environment. Share this article with a colleague

Hedging The 10-Year? Consider DTYS

Summary DTYS provides a well correlated hedge for 10-year treasury bonds. DTYS, like most alternative investments, is associated with significant risks and is intended for achieving short term goals. Recommended for investors who believe interest rates will rise dramatically over an intermediate time frame. Basic Information The iPath U.S. Treasury 10-year Bear ETN (NASDAQ: DTYS ) is an exchange traded note (ETN). ETNs are unsecured, unsubordinated debt securities. This type of debt security differs from other types of bonds and notes because ETN returns are based upon the performance of a market index minus applicable fees, no period coupon payments are distributed and no principal protections exist. DTYS is intended to move inversely (-1x) to The Barclays Capital 10Y U.S. Treasury Futures Targeted Exposure index. The Barclay’s index is tied to U.S. treasury yields. DTYS seeks investment results for a single day only, not for longer periods. A “single day” is measured from the time the Fund calculates its net asset value (“NAV”) to the time of the Fund’s next NAV calculation. The return of the Fund for periods longer than a single day will be the result of each day’s returns compounded over the period, which will very likely differ from the inverse (-1x) of the return of The Barclays Capital 10Y U.S. Treasury Futures Targeted Exposure index for that period. For periods longer than a single day, the Fund will lose money when the level of the Index is flat, and it is possible that the Fund will lose money even if the level of the Index falls. Longer holding periods, higher index volatility, and inverse exposure each exacerbate the impact of compounding on an investor’s returns. During periods of higher Index volatility, the volatility of the Index may affect the Fund’s return as much as or more than the return of the Index. Expense Ratio: .75% + Portfolio turnover (currently 0% because cash instrument and derivative transactions are not included). How Could it be used? If you are looking for a 10-year hedge, DTYS could be a very beneficial to your portfolio. It is highly correlated to the market, and it is a useful tool any skilled investor should consider. In this article, I’ll attempt to illuminate the risks of investing in an ETN, but with adequate forethought DTYS is not a bad strategy, especially with the threat of rising interest rates. Principal Investment Strategy All investment strategies are used in combination to achieve similar daily return characteristics as -1x of the index: Derivatives – financial instruments whose value is derived from the value of an underlying asset or assets, such as stocks, bond, funds, interest rates, or indexes. Swap agreements – Contracts entered into primarily with major global financial institutions for a specified period ranging from a day to more than one year. In a standard “swap” transaction, two parties agree to exchange the return (or differentials in rates of return) earned or realized on particular predetermined investments or instruments. The gross return to be exchanged or “swapped” between the parties is calculated with respect to a “notional amount,” e.g., the return on or change in value of a particular dollar amount invested in a “basket” of securities or an ETF representing a particular index. Futures Contracts – Standardized contracts traded on, or subject to the rules of, an exchange that call for the future delivery of a specified quantity and type of asset at a specified time and place or, alternatively, may call for cash settlement. Money Market Instruments U.S. Treasury Bills – that have maturities of one year or less and supported by full faith and credit of the U.S. government. Repurchase Agreements – Contracts in which a seller of securities, usually U.S. government securities or other money market instruments, agrees to buy them back at a specified time and price. Repurchase agreements are primarily used by the Fund as a short-term investment vehicle for cash positions. These are the Principal Risks associated with TBX Risks Associated with the Use of Derivatives Compounding Risk Correlation Risk Fixed Income and Market Risk Counterparty Risk Debt Instrument Risk Interest Rate Risk Intraday Price Performance Risk Inverse Correlation Risk Liquidity Risk Early Close/Late Close/Trading Halt Risk Market Price Variance Risk Valuation Risk Non-Diversification Risk Portfolio Turnover Risk Short Sale Exposure Risk As you can see below, estimated returns are volatile, and the funds actual results may be significantly better or worse than the underlying index. Bolded values, not including the x and y axis percentages, are where the fund performed worse than expected. This is meant to illuminate the possibility of under or over performance. Theoretical Fund Returns Index Performance One Year Volatility Rate One Year Index Inverse (-1x) of the One Year Index 10% 25% 50% 75% 100% -60% 60% 147.50% 134.90 94.70 42.40 (8.00) -50% 50% 98.00 87.90 55.80 14.00 (26.40) -40% 40% 65.00 56.60 29.80 (5.00) (38.70) -30% 30% 41.40 34.20 11.30 (18.60) (47.40) -20% 20% 23.80 17.40 (2.60) (28.80) (54.00) -10% 10% 10.00 4.40 (13.50) (36.70) (59.10) 0% 0% (1.00) (6.10) (22.10) (43.00) (63.20) 10% -10% (10.00) (14.60) (29.20) (48.20) (66.60) 20% -20% (17.50) (21.70) (35.10) (52.50) (69.30) 30% -30% (13.80) (27.70) (10.10) (56.20) (71.70) 40% -40% (29.30) (32.90) (44.40) (59.30) (73.70) 50% -50% (34.00) (37.40) (48.10) (62.00) (75.50) 60% -60% (38.10) (41.30) (51.30) (64.40) (77.00) Correlation to 10-year yields I aligned DTYS with 10-year treasury yields. Essentially, DTYS is perfectly correlated to yields. Since bond prices react inversely to yields, it is easy to see why DTYS would be a good choice for hedging rising interest rates. Their are other alternative investment tools like the ProShares Short 7-10 Year Treasury ETF (NYSEARCA: TBX ) . DTYS, in my opinion. is the best direct tool for hedging rates. When rates spike, however, their are a number of other options to consider . My advice for any investor is to expose yourself only to risk you feel comfortable with. Conservative plays often pan out better than risky ones in the long run. DTYS is certainly a risky investment with potential for mediocre to negative returns. Conclusion If you are trying to hedge your investment on 10-Year Treasury yields, then DTYS is probably an ETN you ought to consider. However, it is important for any smart investor to weigh the risks associated with any ETN before jumping into any investment long or short. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.